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February 5, 2013

New Frontier for the Yield-Hungry: Student Loans

Being ‘true to your school’ just got a whole lot cheaper for students and investors

College tuition costs skyrocket just as yields nose-dive; combine the two and you may have something.

SoFi, a startup based in San Francisco, is shaking up the student loan market at the time when it’s sorely needed. With four-year tuition approaching the price of a comfortable suburban home, four alumni from the Stanford Graduate School of Business have stuck upon an idea to offer loans at lower costs that are then bundled to investors.

According to Dan Macklin, students like the savings and investors like the yield.

“The origins of the idea came from four students in the Stanford School of Business,” explains Macklin, the firm’s cofounder and vice president of alumni relationships. “We were struck, as were many of our classmates, by the high borrowing costs of student loans, especially at the graduate level.”

He notes that 93% of all student loans are made by the federal government. Stafford loans at the graduate level have an interest rate currently of 6.8% for a direct loan and 7.9% for a Grad PLUS loan. It’s considered quite high in today’s low-interest-rate environment, where mortgages are being refinanced at historically low rates.

Because Stanford is located in the heart of Silicon Valley, the partners noticed the “new and creative ideas going on in the form of crowdfunding and crowdsourcing,” Macklin says, before adding it isn’t quite right for the student loan market.

“The finance industry is a two-way relationship; people deposit money with a bank with really no idea what the bank will do with it, and the bank makes loans and customers really have no idea what will happen to the note after that or if it will be sold off,” he argues.

SoFi process, he counters is very transparent. It’s an idea that relies heavily on social networking—media and otherwise. The key is to involve school alumni and other interested investors—someone with a child enrolled at a particular school, perhaps.

“In the summer of 2011, we began with $2 million from 40 investors and made loans to 100 Stanford Business School students. We have since expanded to 79 schools and $100 million. This year, we expect to $800 [million] and we’re broadly on track to reach that now that we’re one month in.”

Macklin notes that although they reach out to schools to explain the concept, they don’t need the institution’s blessing, as students can borrow from wherever they like. The company is currently seeing $10 million of demand, on average, each week.

“The students see that we are a proper company sending proper statements and from there the idea is spread through word-of-mouth,” he adds.

SoFi initially concentrated on borrowers, preferring to establish a solid track record before approaching investors. As a result, it prefunded many of the early loans.

With the aforementioned track record in place, the firm has begun approaching investors “for three or four months now.”

“In this ongoing search for yield, assuming there is no leverage, the investor receives all of what the borrower pays minus our fees, which works out to 4% or 5%,” Macklin claims. “With leverage, assuming some sort of securitization down the road, the return can reach double digits.”

For those with an aversion to the word securitization in the wake of the AAA-rated subprime loan debacle, Macklin notes the high quality of the loans being made.

“The students we work with are from schools with historically low default rates—Harvard, Stanford, MIT—which are less than 1%,” he says. “The government publishes its student loans default rates, which are obviously much higher. The government doesn’t do any credit underwriting, but we do. Also, 85% of the loans we make are refinanced loans to people who have already graduated. We feel all of these factors will reduce the default rate at the schools we work with even lower.”

But the key, he argues, is the social component.

“Schools are communities, and many students might have already reached out to alumni—who are often also investors—for job or career advice. If someone does lose their job, there is a network of people that have a vested interest in making sure that person gets another job and can continue to pay off the loan.

The firm has 50 staffers, of which about 20 are dedicated to raising capital and “getting the word out.” As it is a private placement, they’re limited in their marketing efforts under Regulation 144, so getting to the word out means relying on their own networks. Social media has also been a resource, in particular LinkedIn, which lists the school on a person’s profile page.

People are searching for alternatives to find yield,” Macklin concludes. “Many of these same people have a natural affinity for a school, so combining the two makes for something very interesting.”